Expectations for the Multifamily Investment Market: July, 2020
Over the past few months, the U.S. breathed a collective sigh of relief in the fight against COVID-19. In late March and early April, uncertainty and fear dominated the headlines and markets. JP Morgan predicted a 20 percent unemployment rate for Q2 and U.S. cities locked down in an attempt to prevent the propagation of New York’s shocking hospital scenes. Since the early days of April, the expense to human life and to the U.S. economy has grown at a considerably lower rate than initial projections. However, with new cases sprouting up across several states and some reopening orders placed on pause, the nation still faces a formidable challenge in suppressing the virus. We cannot discount the nearly 2.7 million cases in the U.S., but government and health officials are now equipped with the fruits of experience: better tracking information, increased communication with hospital systems, a coordinated policy response, and a new treatment to reduce the length of hospital stays. For the U.S. multifamily investment market, a similar narrative of increasing optimism shows that with each passing day, and rent payment processed, multifamily real estate is once again rising to its long-held expectation as a stable and resilient investment.
The expected returns produced by multifamily assets are largely a function of two things: price and expected future income growth. In March 2020, both of these factors fell victim to immense uncertainty. Pricing guidance vanished as the capital markets froze and projected income growth became precarious as questions mounted on the ability of tenants to make rent payments, on the future of domestic migration within the U.S., and on the future of jobs as unemployment skyrocketed. Since March, much of this fog of uncertainty has lifted surrounding these questions.
Earlier in June, The Federal Reserve estimated that the national unemployment rate will fall to roughly 9.3 percent by year-end and 6.5 percent by Q4 of 2021. In CONTI’s Texas market, the state unemployment rate fell to 13 percent in May, below the U.S. rate of 13.3 percent. In the populous and economically diverse metro areas of San Antonio, DFW, and Austin, unemployment fell to respective rates of 12.7, 12.3, and 11.4 percent in May. Although the economic effects of the coronavirus are far from over, Texas is weathering the storm relatively well. These strong macroeconomic indicators allow greater confidence for projecting future income growth of assets, but these indicators would be meaningless if renters did not continue to meet their contractual obligation to pay rent.
At the onset of the coronavirus panic in March, the U.S. federal government effectively erased this obligation by temporarily eliminating important tools that multifamily operators use to enforce contracts with tenants; tools like penalties for late rent payments and evictions for non-payment. While these tools are set to resume by September, the multifamily industry heavily scrutinized monthly rent payments since March. Despite the initial fear of tenants widely ignoring their rents without penalty, payment data over the past 3 months is overwhelmingly positive. The National Multifamily Housing Council’s analysis of over 11 million U.S. apartment units shows that as of June 27th, 94.2 percent of tenants have made a full or partial rent payment for the month.
With positive U.S. economic indicators and strong cooperation from tenants, the industry’s attention turns to solidifying future income (rent) growth projections. According to data provider, Yardi Matrix, May rents increased 0.8 percent year-over-year on a national scale, however; average rents fell in both April and March. Typically, the spring leasing season buoys rent growth for the year, so these declines likely mean flat or contracting rents across the nation for 2020. Yardi also reports that the Renter-by-Necessity cohort, a segment of the multifamily market that routinely includes a large portion of Workforce assets, outperformed the “Lifestyle” or luxury asset class in terms of both year-over-year and month-over-month rent growth in May. While this national data provides a useful framework for analyzing the multifamily investment market, a nuanced perspective reveals stark regional differences within the U.S.
Figure 1. NMHC Monthly Rent Payment Comparison for Selected Months in 2019 and 2020
Like any housing investment, expected future income growth for multifamily is driven by the movement of people and job creation. Before the coronavirus crisis, CONTI targeted the strongest market within the U.S. for population and job growth – Texas. We believe that the fundamentals of Texas, and other low-cost of living southern U.S. markets, remain relatively sheltered from the pandemic’s economic toll. Given the recent data reported from high-cost coastal markets like San Francisco and New York, where renters are now signing leases at 8 percent discounts, CONTI also sees an acceleration of previous demographic trends due to the pandemic. Americans will expedite their migration from high-cost and crowded coastal cities to the low-cost and dispersed scene of southern U.S. cities like Dallas and Austin.
CONTI remains confident in our multifamily outlook for 2020; the key indicators of future income growth are strong and promising for our target markets. However, the other essential component of expected returns, pricing, is beginning to reflect the broader economic and demographic trends that we have witnessed throughout: multifamily investors are flocking to the southern U.S. and specifically Texas. As a consequence of increased demand for fundamentally sound multifamily assets in Texas, CONTI is already observing a spike in pricing to pre-coronavirus levels. Searching for steep discounts in the Texas multifamily market, and more broadly, the southern U.S. will not yield success, as the discounts seen following the Great Recession are not present in today’s environment. Aside from the compelling fundamentals of the southern U.S., which draws capital from around the globe and lifts prices locally, the market dynamics of 2020 simply discourage any bargain-hunting strategy.
Upon close inspection of multifamily in 2020, the market is markedly different from the last large distressed buying opportunity during the 2008 Great Financial Crisis (GFC). Many of the distressed opportunities of 2008 arose from riskier lending practices through CMBS and Investor-Driven loans. During 2007, nearly half of the outstanding debt within the U.S. apartment market was owed to these riskier lenders. In response to the failure of the financial system, these lenders came under greater scrutiny from regulators to prevent a future collapse. With greater scrutiny came decreased market share.
Figure 2. Real Capital Analytics Comparison of Multifamily Market Lender Composition 2007-2019
Today, the apartment lending market is dominated by the lenders with the lowest tolerance for risk, the Government Agencies of Fannie Mae and Freddie Mac. This fundamental shift in risk over the past decade has generally insulated the apartment market from distress. A key metric of distress, the share of real estate deals falling out of contract, displays the overall stability of the market when compared to the GFC. According to Real Capital Analytics, the number of commercial real estate deals falling out of contract blipped up to 2.9 percent of closed deals in May, nowhere near the peak of 12.8 percent seen in January 2009.
While the Great Financial Crisis allowed outsize returns for those multifamily investors who subscribed to a strategy targeting distressed assets and severely inefficient operators, no lucrative strategy goes unnoticed in a competitive market. Over the past decade, the abundance of inefficient operators with hugely underperforming assets dwindled to a rare few. The reality of our target Texas markets is one of intense competition and a resulting overvaluation for many of these “rare finds.” We do not expect an abundance of distressed opportunities in our Texas markets if any.
As of July, CONTI’s outlook on the multifamily investment market is largely positive. We believe the foundations of future income growth, people, and jobs continue to firmly favor the low-cost markets of the southern U.S. With this strong foundation, these markets will likely see a general increase in prices. As more capital reallocates to the stability of multifamily real estate, CONTI envisions continued upward pricing pressure in the second half of 2020. In light of future uncertainties, we will continue to carefully monitor the health of our markets, economic indicators, and the policy response of lawmakers. Assuredly, CONTI’s rigorous underwriting process enables our team to filter out inadequate deals on the grounds of both expected future income growth and price while maintaining our commitment to providing the best risk-adjusted returns.